The Federal Reserve knew speculation was rampant in 1929 but hesitated to raise interest rates. They were scarred by the political backlash from raising rates in 1920, which they were blamed for causing a brief but sharp recession. This fear of political reprisal contributed to their paralysis.
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Rajan suggests that a central bank's reluctance to aggressively fight inflation may stem from a fear of being blamed for a potential recession. In a politically charged environment, the institutional risk of becoming the 'fall guy' can subtly influence policy, leading to a more dovish stance than economic data alone would suggest.
The 1920s bubble was uniquely driven by the new concept of retail leverage. Financial institutions transported the nascent idea of buying cars on credit to the stock market, allowing individuals to buy stocks with as little as 10% down, creating unprecedented and fragile speculation.
Instead of raising interest rates, the Fed in 1929 relied on "moral suasion"—sending letters asking banks to stop lending to speculators. This vague, unenforceable policy was largely ignored by bankers who questioned the definition of a 'speculator,' proving ineffective at cooling the market.
The Federal Reserve’s decision to end Quantitative Tightening (QT) is heavily influenced by a desire to avoid a repeat of the 2019 funding crisis. The 'political economy' of the decision is key, as the Fed aims to prevent giving critics 'ammunition' by demonstrating it can control short-term rates.
The Federal Reserve is pressured to cut rates not just for economic stability, but to protect its own independence. Failing to act pre-emptively could lead to a recession, for which the Fed would be blamed. This would invite intense political pressure and calls for executive oversight, making rate cuts a defensive institutional maneuver.
The Fed faces a political trap where the actions required to push inflation from ~2.9% to its 2% target would likely tank the stock market. The resulting wealth destruction is politically unacceptable to both the administration and the Fed itself, favoring tolerance for slightly higher inflation.
The Federal Reserve's independence is crucial for long-term economic stability because it prevents presidents from succumbing to the political temptation of lowering interest rates for short-term popularity, a move that risks spiraling inflation.
The Federal Reserve, a relatively new institution in 1929, acted timidly due to political pressure. It failed to curb rampant speculation before the crash and then hesitated to inject liquidity after, fearing it would lose its authority. This inaction, born from political weakness, was a key lesson that informed the aggressive response to the 2008 crisis.
Despite the perception of independence, the Federal Reserve historically yields to political pressure from the White House. Every US president, regardless of party, has ultimately obtained the monetary policy they desired, a pattern that has held true since the Fed's creation.
The Fed faces a catch-22: current interest rates are too low to contain inflation but too high to prevent a recession. Unable to solve both problems simultaneously, the central bank has adopted a 'wait and see' approach, holding rates steady until either inflation or slowing growth becomes the more critical issue to address.
